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Not your father's financial system

In my interview with Sen. Carl Levin today, he said that "the nature of Wall Street's function has changed. They still argue that they're providing capital and stimulating innovation, and to some extent they are. But there's been a significant shift here to the model where they're out for themselves. Their client is themselves."

An imperfect, but useful, analogy would be to think of a trucking company. For most of its history, the company made money moving cargo from one place to another. The economic benefit of this activity is, of course, clear. But eventually, it found a way to make much more money betting on whether other trucking companies would deliver their cargo on time. And then they realize that they could bet on airplane arrival times and auto racing and all sorts of other things. So now they do some trucking and some betting, but the majority of their profits come from betting. Jane D'Arista explains this clearly:

Proprietary trading is the name for trades that banks make for their own accounts, not for their customers. It’s done by the largest banks and investment banks, but also by any sizable institution that can access the repurchase agreement (repo) market and borrow the funds needed to buy assets or take derivatives positions that generate profits for themselves. There is no economic benefit. And it is risky. Prop trading only works if they can borrow enough to substantially leverage their own capital. They have to set up a situation in which the cost of borrowing is lower than the return on the assets or derivatives in which they are investing.

This is important when thinking about financial regulation because a lot of Wall Street's defense comes from conflating the two activities. It’s true that we don't want to impede the financial system's ability to get capital to people who need it, just like we wouldn't want to stop truckers from getting cargo where it needs to go. But we may well want to impede the ability of too-big-to-fail companies to make giant bets that could go bad and then throw the system into chaos, harming the system's ability to get capital to people who need it.

By Ezra Klein  |  April 30, 2010; 4:20 PM ET
Categories:  Financial Regulation  
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Comments

FinSys.

It's called FinSys.

Posted by: pj_camp | April 30, 2010 4:37 PM | Report abuse

A small quibble. There is an economic benefit to trading - better pricing and liquid financial markets.

The issue is not whether trading provides no economic benefit, just whether or not that benefit - on the margin - exceeds the costs - also on the margin. I think most observers agree that the cost in terms of risk taken by the banks exceeds the benefits.

Posted by: justin84 | April 30, 2010 4:42 PM | Report abuse

Another conflation: innovation in the financial markets with innovation that, uh, really creates wealth.

Posted by: Lonepine | April 30, 2010 5:10 PM | Report abuse

Sorry -- that's a little too simplistic.

Dealer firms trade for their own accounts, at least in part, because their customers need them to. There may not be a natural counterparty; the dealer firm provides its capital. That's the difference between a principal market and an agency market.

Of course, the firm also wants to make money when it trades for its own account. I don't really think that's a problem.

The problem arises when the firm seeks to magnify its returns through leverage. It works very well -- until it doesn't. And when a big firm goes down, there's a contagion effect.

Meaningful capital standards are an essential element of reform. Preventing, or greatly restricting, firms from trading for their own accounts, in contrast, will reduce efficiencies and drive up costs.

Posted by: Craig643 | April 30, 2010 6:54 PM | Report abuse

Is it too "simplistic"?

A market maker takes trades from one party (I want to buy Apple at $5!) and sells them to another party (I want to sell Apple at $5.25) and makes money on the spread. Fine, you're adding liquidity.

If you're offering a trade because there is no "natural counterparty" aren't you pretty close to trading in your own interest. There is currently no natural counterparty to my wanting to buy Apple for $5. Wanna take the trade? Or would that not be in your interest?

It's not rocket science. It's a market.

Posted by: BHeffernan1 | April 30, 2010 7:27 PM | Report abuse

Ezra,

The title of this post made me think of a book I had read recently:

http://www.amazon.com/Jimmy-Stewart-Dead-Ongoing-Financial/dp/0470581557

It's worth a look.

Posted by: justin84 | May 2, 2010 9:45 PM | Report abuse

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